Building a Basic Revenue Model
When building a model for a startup or other company with limited history, it’s usually advisable to start with a revenue model. A revenue model is a piece of a larger financial model which, as the name might suggest, presents how revenue will be obtained.
After answering several of the critical questions posed in an earlier post, you should have a pretty good idea of what your company sells, how it’s sold, and how it’s purchased. Although the principles are the same whether you’re selling a product, a service, or something else, for purposes of this discussion, we’ll assume that we are selling two products, one which is only purchased once, and one which is a monthly recurring purchase. An example of such a business would be one which sells a razor with disposal razor blades. To build a revenue model for our business it’s critical to follow these basic steps:
- Identify the critical “unit” – In the case of our razors, this model assumes that the unit is a single razor as opposed to a case of razors. In the case of our razor blades, this model assumes that a single package of blades must be purchased each month, which is driven by the number of current and prior customers.
- Understand the per unit revenue – We’ll assume the razor costs $5, and the blades cost $3 per package.
- Understand how the revenue will be earned throughout the year – In order to add a little complexity to our model, we’ll assume that 25% of our razor sales come in December (holiday gifts) and the rest of the razor sales occur equally throughout the year. Our razor blades will be sold to existing customers only, since new customers will receive a one-month supply with the initial razor purchase.
- Understand other internal or external drivers – We’ll assume that our annual sales are 10,000 units of razors and that 1% of our customers will “churn” or, in other words, that we will lose 1% of our razor blade customers each month. This is a new business, so the company has no sales in month 1.
Given all that, let’s start with the easiest part, the assumptions. Below, we’ve included our initial assumptions of price per unit, annual sales, churn rate, and how we anticipate our razor sales to develop through the year. The 6.8% of revenue associated with the months of January – November was simply calculated as 75%/11, since we are assuming that 25% of our razor sales will come in December.
Next, let’s calculate our razor sales by month. This is simply the 10,000 total annual razor sales times the razor sales percentage. We end up with a spreadsheet which looks like this:
Step three is the calculation of customers. This is a little bit more complicated, but is based on this basic formula: beginning customers, less churn, plus new customers, equals ending customers. With this as framework, assume the razor sales represent our “new customers” for the month. The churn is 1% of the beginning balance of customers. Our beginning number of customers in January is zero, so the ending customers would just be 0-0+682 or 682. This ending balance becomes the beginning balance of customers for February, and the cycle continues. You end up with something that looks like this:
Finally, we calculate revenue for our “razor” and “razor blade” product lines. The razor revenue is just the number of razor sales in a given month times our $5 price. The razor blade revenue is calculated as the (beginning balance of customers less churn) times the razor blade price per unit.
And, there you have a basic revenue model for our razor company. And, based on our $222 thousand of anticipated revenue, not a bad little business in our first year.
We’ve posted a free version of this model in the models section of the site. You can find the specific revenue model here.